By Ben Levisohn

In an effort to stem the tide, the Reserve Bank of India has moved to tighten rupee liquidity, by limiting overnight borrowing, and curtail trading in currency derivatives, for example. The measures came after India’s currency hit all-time lows against the dollar recently. There was an immediate impact, with the rupee climbing to its highest level against the U.S. dollar in two weeks on Tuesday.

Morgan Stanley considers the impact on India’s stock market:

The RBI chose to defend the currency overnight by quantitative tightening (reducing rupee supply), and this may take its toll on the equity and bond markets. It increases the downside risks to growth, raises the cost of money and dampens domestic liquidity. From an equity market perspective, we think this puts a cap on the markets in the coming weeks. We reset our year-end base case for the BSE Sensex to 21500 (from 23097) on the back of this. Our bull case also falls to 23000 (from 28137 – given the change in earnings and rise in cost of capital) though our bear case is unchanged at 17918. Our probability-weighted Sensex target for 2013 is now 21084 (versus 23069 earlier) representing upside of 5%.

Morgan Stanley also recommended that investors avoid stocks with high “betas,” or volatility relative to the overall market, and leverage. Indian stocks on its focus list include Tata Motors (TTM), ICICI Bank (IBN) and Infosys (INFY).

India’s BSE SENSEX Index dropped 0.9% today, but its rupee gained 1.1% against the dollar, according to FactSet. That combination means that U.S. ETF’s tracking Indian stock indexes have actually gained a smidge today: The iShares MSCI India Index (INDA) has ticked up 0.1% to $24.37 and the WisdomTree India Earnings ETF (EPI) is up 0.03% at $16.80.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. Barrons.com’s Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools. She studies multiple languages and photography.